Make Your Money Last in Retirement

In this series we’ve talked about how to handle your money in retirement. As stated in the first post, there are three competing concerns when managing money in retirement. These are:

To generate enough income for expenses.

To have the amount of money you possess grow over time so that you’ll be able to keep up with inflation.

To make your money last for the rest of your life.

We’ve discussed income assets and how to use them to generate the cash you’ll need when you’re retired, plus we’ve discussed assets that will allow your portfolio to grow over time. Today we’ll talk about using both of these tools, combined with proper money management, to make your money last and provide the income you need through retirement.

The only way to be assured that your money will last through retirement is to spend less than you make each year plus have your portfolio grow to keep up with inflation and so that the income you receive will grow each year as well. A downside of this is that you’ll end up with a lot of money left over when you die, which is good fortune for your heirs but seems like kind of a waste. It is sort of like buying the fuel option on a rental car where you bring back the tank empty – you normally end up leaving a lot of gas in the tank because you don’t want to run out on the way to the airport. The other option is to plan to spend a little of the principle each year based on how long you expect to live, but of course you take the risk of running out of money that way if you live longer than you expect. A third option is to buy a deferred annuity that kicks in and provides income when you reach some really old age, like 85. This is like buying an insurance policy in case you outlive your money.

A normal plan is to invest part of your money in income securities and part in growth securities. The income securities provide money for living expenses and stability to the portfolio while the growth assets allow the value of the portfolio to grow and keep up with inflation. Doing this, a portion of the portfolio is withdrawn each year – normally 3-4% – while the rest is reinvested.

For example, a 65 year-old might have a $1 M portfolio that is 50% income securities and 50% stocks. If the income portfolio has an average return of 6%, that would produce $500,000 x 6% = $30,000 in income each year. The retiree might withdraw that $30,000 and use it for expenses. That, combined with Social Security, might provide $50,000 in income per year.

The 50% stock portion of the portfolio would increase and decrease in value. Over long periods of time, like 10-15 years, it should produce a return of between 10-15%. This means it would double about every 5-7 years, so the retiree might have $2 M in growth stocks by the time he reaches 75 or 80 if he left the stock portfolio untouched. Of course, he would be selling some of his growth portfolio each year and adding to his income portfolio so that he could keep his income level up with inflation. He might therefore actually only have $1 M in stocks and $1 M in bonds by the time he reached 80 with an income of about $80,000 per year. This would continue, with money being shifted into income from growth, until he was perhaps 90 and had 90% income assets. At that point he would probably not have too much longer to live so he needn’t worry about inflation very much.

One issue with this strategy is that it assumes fairly benign stock market activity. The greatest danger is that the market takes a severe tumble like 2008 right when our retiree starts his retirement. That might cause him to panic and sell all of his stocks, locking in the losses and guaranteeing him a lower level of income throughout his retirement. Another issue is that interest rates may be really low when the retiree starts retirement, forcing him to take chances to generate the income needed, perhaps resulting in defaults and losses in his income portfolio.

A second strategy is to forego the income portfolio entirely and use a large stock pile of cash combined with a portfolio of stocks, including both growth and income stocks with the dividends reinvested, and then to sell off stocks to replenish the cash as needed. The idea is to keep enough cash on hand to weather downturns int he markets, but not so much cash as to see it erased by inflation. For example, one might start with five years’ worth of cash on hand, sell stocks to add to the cash during good market years, and then hold onto stocks and wait for them to recover during down years. This strategy would make sense particularly during times when interest rates are very low and therefore it is difficult to find income assets that both pay a good rate of return and are safe.

Probably the best thing to do is to save about twice what you think you will need for income in retirement. This would allow you to treat a portion of your portfolio in one of the standard ways, then invest the rest in growth securities. You would get a much better rate of return over long periods of time but also be able to wait out downturns since you still have the basic portfolio to generate needed income.

Your investing questions are wanted. Please leave them in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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